Monday, July 02, 2007

On Charlatans and Cranks

Jared Bernstein, a bigshot at the left-wing thinktank Economic Policy Institute, seems to think I am a hypocrite. He writes:

Economists sometimes serve vested interests, and will change their views accordingly. The best example is also one of the best economists, Greg Mankiw. This textbook-writing Harvard prof was Bush’s chief economist for awhile, and during his confirmation hearing and subsequent tenure at the White House, he constantly defended Bushonomics, including supply-side beliefs that he once argued were the musings of “cranks and charlatans."

The problem is, he did not check his facts.

I used the phrase "charlatans and cranks" in the first edition of my principles textbook to describe some of the economic advisers to Ronald Reagan, who told him that broad-based income tax cuts would have such large supply-side effects that the tax cuts would raise tax revenue. I did not find such a claim credible, based on the available evidence. I never have, and I still don't.

The book made clear that the critique applied to a particular reason to favor the tax cuts, not necessarily to the policy of cutting taxes. There are many reasons a person might favor tax cuts besides the belief that tax cuts are self-financing. I hope it is not too pedantic to point out that there is a big difference between rejecting a policy and rejecting one argument made by some proponents of the policy.

In the second edition of the text, I took out the phrase "charlatans and cranks" because an editor and some readers of the first edition said (correctly) that it was too inflammatory for a textbook description of a policy debate. But the substantive analysis of tax policy stayed about the same. This old post includes an excerpt from the current edition.

My other work has remained consistent with this view. In a paper on dynamic scoring, written while I was working at the White House, Matthew Weinzierl and I estimated that a broad-based income tax cut (applying to both capital and labor income) would recoup only about a quarter of the lost revenue through supply-side growth effects. For a cut in capital income taxes, the feedback is larger--about 50 percent--but still well under 100 percent. A chapter on dynamic scoring in the 2004 Economic Report of the President says about the the same thing.

I don't have a problem with a person changing his mind over time based on new evidence and new thinking. So even if I had changed my mind on this issue and somehow decided that broad-based tax cuts were self-financing, I would not feel bad about it. But the truth is, I haven't changed my mind. If anyone tells you I have been inconsistent on this issue, you can be sure that he is either a charl....

Okay, let's just say he is mistaken.

Update: Mr Bernstein emails me a response:

Prof Mankiw,

Having read your website reacting to my TPM post, you and your readers got me all wrong. I certainly didn't accuse you of hypocrisy and meant no offense at all. In fact, I called you one of the best economists, and have always enjoyed your work, especially appreciating the clarity of presentation. (A few years ago Larry Ball came over to EPI and presented an excellent joint paper by the two of you.)

Reread my post and you and your readers will see that I was making no substantive comments at all about your views on supply-side. I was asserting that your economics, as I understand them, are quite different from Bush economics, as I understand them. And I raised the supposition that perhaps you thought you could move economic policy in a better direction.

In this spirit, I raised the question, as Brad DeLong put it in his comment about this: is it worth the sacrifice of the economics profession's outside credibility and the further confusion of the public that is entailed when good economists defend bad policies on the outside that they are working to change on the inside?

My answer is 'no'--yours is 'yes.' I'm by no means sure I'm right and it seems to me that this is an important discussion, one worthy of your attention. Your comments about your different textbook editions and your defense of your view on the revenue impacts, while interesting, are beside the point. I fear that when great economists like you align themselves with folks like these, it hurts our credibility, and makes it harder for us to bring our analysis to bear in objective ways. I know that you and year readers are critical of EPI in this spirit as well, and I'm happy to have that debate too. In fact, the one critique from your readers that made sense to me was the one that said I should have used some examples where left-leaning analysts make unjustified assumptions leading to inaccurate predictions. Good point.

Anyway, keep up your good work--I'm with you on energy taxes--and jeez, I'd have thought you'd have a thicker skin after hanging around DC!

Perhaps you could post this on your site.

Sincerely,--Jared

For the record: I do not agree with the view that Mr Bernstein ascribes to me about good economists defending bad policies. He seems incredulous that I could honestly favor the Bush tax cuts. But I do. Here is what I said on the topic in a speech in 2003:

The U.S. economy is remarkably flexible and resilient. Had we done nothing, the economy would eventually have recovered from the recession. But the actions the President took made the recession less severe.

As the President has discussed, analysis done within the Administration has shown how his tax cuts have substantially offset the series of adverse shocks that have been buffeting the economy. Simulations of a conventional macroeconomic model show that, without the tax cuts, the level of real GDP would have been about 2 percent lower in the middle of 2003. About 1.5 million fewer people would have jobs today. The job market is not what we would like it to be right now, but it would have been worse without the Administration’s actions.

One can view the short-run effects of these tax cuts from a classic Keynesian perspective. The tax cuts let people keep more of the money they earned. This supported consumption and thus helped maintain the aggregate demand for goods and services. There is nothing novel about this. It is very conventional short-run stabilization policy: You can find it in all of the leading textbooks.

But in addition to providing a Keynesian stimulus to consumption, the tax cuts also addressed today’s most important cyclical problem: sluggish investment. As you know, the 2001 recession was unusual in the degree to which weak investment was a central driving force. Investment weakened substantially starting in 2000, as firms joined stock-market investors in reevaluating prospects for future earnings growth and developed a reduced tolerance for risk in the aftermath of the bubble. The corporate governance scandals may also have played some role in reducing the willingness of corporate CEOs to take on risky projects.

To counter these developments, the Administration’s tax cuts were designed to give businesses increased incentives to invest. The package included lower taxes on dividends and capital gains; enhanced expensing for small businesses; temporary bonus depreciation; and elimination of the estate tax. In addition, lower individual tax rates help sole proprietorships, partnerships, and S corporations. For these taxpayers, income flows through to their individual tax returns. All of these initiatives lower firms’ cost of capital.

The tax cuts have thus supported demand—both consumption and investment. This will help bring the economy back closer to potential. We are not there yet, and clearly not so in the labor market. But there are indications that the economy is firming, and we expect progress in the labor market to follow.

The Administration’s tax cuts, however, should not be viewed only from a short-run perspective. They were also designed taking into account the important long-run, supply-side effects.

Lower marginal tax rates on both labor income such as wages and on capital income such as dividends and capital gains improve incentives and so boost growth in potential output. We will not just get back to potential; instead, we will have a new and better long-run growth path.

Lower marginal tax rates on wage income will increase work effort, while lower taxes on capital income will increase investment and thus capital accumulation. More capital means that each worker has more tools and is more productive, and improved productivity means higher wages. In addition, lower taxes on dividends and capital gains, as included in the most recent tax bill, also reduced the unequal tax treatment of corporate and noncorporate capital. Moving toward a more level playing field between different types of capital will increase efficiency, as capital is allocated with more of a focus on profit and less concern for tax avoidance.

The qualitative effects of these tax changes on the short-run output gap and on long-run potential output are not controversial. There is less agreement on quantifying these effects—how many jobs were created, how much growth was increased, and so on. To answer these questions, one would normally turn to a macroeconomic model such as those maintained by private forecasting firms, the Federal Reserve, and other institutions. I view such models as being very useful at relatively short time horizons such as one or two years. Over this horizon, demand-side effects predominate.

These models, however, typically devote less attention to supply-side effects. So beyond 18 or 24 months when supply-side factors become increasingly important, one should be careful to recognize the limitations of these models.

This issue is of great relevance for “dynamic scoring.” Tax economists are quite good at estimating the static score of a tax cut, which you can view as the “sticker price.” But it is very likely that this sticker price is an overestimate of the true budgetary cost. To estimate the true cost of a tax cut, we need to know the long-run effects of a policy on tax revenues. Tax revenues depend on potential output, which in turn responds to tax incentives. Unfortunately, macroeconomic models of the supply side are still very much works in progress. I will return to this issue in few minutes....

As I have already mentioned, another area in which the standard analysis of tax policy misses the mark is in the projections of the budgetary costs—the “scoring” of a tax bill. The standard analysis assumes that changes in tax policy do not have any macroeconomic effects. That is, tax cuts are assumed not to affect economic growth, either in the short run or in the long run. It is as if a tax on ice cream machines were assumed to have no impact on the market for ice cream.

Although it is hard to estimate the impact of a tax cut on output, we know that it is not likely to be zero. The standard “static scoring” uses a precise but wrong answer—zero—to derive the “sticker price” of a tax cut.

Conventional scoring does allow for the possibility that individuals change behavior in response to tax cuts. For a capital gains tax cut, for example, conventional scoring recognizes that capital gains will be realized more frequently. But the analysis does not recognize any macroeconomic effects on investment or output.

As a result, the true price of a tax cut differs predictably from the sticker price, as higher growth will lead to more revenue. I do not believe the revenue feedback is enough to fully pay for a tax cut in most cases, but it is likely to make a meaningful offset. For looking at the short-run costs of tax policy, the dynamic effects need not rely on supply-side phenomena; they can be based on the simple Keynesian demand-side effect of fiscal policy. Over a longer horizon, supply-side effects will be more salient.

I do not think anyone can be confident about how much the true “dynamic score” of a tax change differs from the “static score.” This is a hard problem. It is no criticism of people who work on scoring that they have not yet perfected the art, particularly in light of the time and resource limitations they face.

One thing to keep in mind, however, is that because of their effect on capital accumulation and thus on potential output, capital tax cuts are likely to cost less over the long run than other types of tax cuts. That is, a tax cut that lowers the cost of capital will widen the tax base by more than a tax cut of equivalent size on labor income.

Of course, the expansionary effects of the tax cuts will be offset to some degree by the effects of the budget deficits that arise from lower revenues. Deficits can raise interest rates and crowd out of investment, although I should note that the magnitude of this effect is much debated in the economics literature. The main problem now facing the U.S. economy is not high interest rates, but at some point continued deficits would matter and could impede growth. This is why, as the President has said, spending restraint is so vital.

The Administration would prefer not to have deficits, but deficit reduction is only one of many goals. Reversing the tax cuts today, as some have suggested, would depress growth and job creation. This is a matter of priorities: In the face of a shrinking or barely growing economy, an investment slowdown, and continued job losses, the President made growth and jobs his number one economic priority. There are others who think he should make deficit management the top priority – but the Administration does not share that point of view. Deficits are worrisome, but not as worrisome as an economy that is not growing and is rapidly shedding jobs.

It is also important to be aware of how these deficits arose. About half of the change in the fiscal outlook since the President took office is attributable to the weak economy, including the stock market. About a quarter is due to higher expenditures, mainly on homeland security and defense. The last quarter is due to reduced revenue from the tax cuts. And these estimates are based on static scoring, so they surely overstate the role of the tax cuts.

What is important is to have a plan under which the deficits shrink over time relative to the size of the economy. This is the case under the President’s policies. The deficit as a share of GDP is projected to diminish by more than half over the next five years.

The most important fiscal challenge facing the United States is not the current short-term deficits, which will shrink, but instead the looming long-term deficits associated with the rise in entitlement spending as the baby boom generation retires. This challenge is simply the march of demographic destiny combined with our pay-as-you-go entitlement system. It is not a new challenge, and it was not created by tax cuts or solved by previous tax increases. The President’s Budget has correctly called this issue “the real fiscal danger.”

About Me

I am the Robert M. Beren Professor of Economics at Harvard University, where I teach introductory economics (ec 10). I use this blog to keep in touch with my current and former students. Teachers and students at other schools, as well as others interested in economic issues, are welcome to use this resource.